A Euro­pean head fake

Should in­vestors be wor­ried by a Ger­man bond mar­ket sell-off that has seen 10-year bund yields rise some 30bp over the last month? The last time Euro­pean yields climbed this quickly, in early 2015, eu­ro­zone stocks swooned in the fol­low­ing year, with the bench­mark in­dex fall­ing -27% peakto-trough. More­over, un­like the US which has seen a long ex­pan­sion, it is not clear that a still weak eu­ro­zone can han­dle a rise in the cost of money.

It should, of course, be recog­nised that there are good rea­sons for Ger­man yields to rise. Af­ter the Brexit ref­er­en­dum, worst case sce­nar­ios for the UK—a key trad­ing part­ner for big eu­ro­zone economies—have yet to ma­te­ri­alise. While eu­ro­zone growth in 3Q16 came in un­changed at 0.3% QoQ, the latest PMI read­ings point to a stronger fourth quar­ter. There are even in­cip­i­ent in­di­ca­tions of a pick-up in ex­port de­mand from Asia. To­gether with ris­ing in­fla­tion ex­pec­ta­tions due to oil price base ef­fects, bond in­vestors want to be com­pen­sated, which is not un­rea­son­able since eu­ro­zone bond mar­kets had be­come just about the world’s most over­val­ued.

Still, there re­mains a sus­pi­cion that this is not the full story. It does not fac­tor in the sharp fall in ster­ling which must slow UK im­ports over the com­ing quar­ters. Sec­ond, po­lit­i­cal risks still loom large with the Ital­ian ref­er­en­dum just five weeks away and polls mov­ing against the govern­ment’s po­si­tion.

In truth the key trig­ger for ris­ing eu­ro­zone bond yields has been the lack of clar­ity over Euro­pean Cen­tral Bank pol­icy. The sell-off started right af­ter the ECB’s Septem­ber meet­ing when Mario Draghi de­clined to sig­nal an ex­ten­sion of its quan­ti­ta­tive eas­ing pro­gram be­yond its March 2017 ex­piry. The flight to safety amid jit­ters over Deutsche Bank’s sol­vency in mid-Septem­ber pro­vided a brief respite, but by early Oc­to­ber yields were again ris­ing on news re­ports of a loom­ing ECB bond pur­chase ta­per.

A ta­per, how­ever, is un­likely to ma­te­ri­al­ize any­time soon and QE is al­most guar­an­teed to be ex­tended for one more pe­riod. One key rea­son is the fact that credit growth re­mains ex­tremely slug­gish. The latest bank lend­ing data showed that the eu­ro­zone credit im­pulse—the change in credit flows to the non-fi­nan­cial pri­vate sec­tor as a share of GDP—has weak­ened and is now trend­ing down­ward. The credit im­pulse mat­ters be­cause it has pre­vi­ously led do­mes­tic de­mand growth, the main driver of the eu­ro­zone re­cov­ery. With a few ex­cep­tions, lend­ing to the pri­vate sec­tor re­mains weak, giv­ing cre­dence to the view that ECB poli­cies are in fact crimp­ing banks’ ca­pac­ity to lend. That may be the case, but it seems likely from Draghi’s re­cent com­ments that the ECB still sees the medicine as hav­ing ben­e­fi­cial ef­fects, so the most likely course of ac­tion is a dou­ble-down on the pol­icy. From a re­cent speech by ECB Board mem­ber Benoit Coeure it is clear that the ECB sees QE and neg­a­tive in­ter­est rates as the right pol­icy mix to ad­dress real equi­lib­rium rates which are at or be­low zero and a struc­tural growth rate that con­tin­ues to de­cline.

If this ar­gu­ment is right, the ques­tion is why the ECB en­gaged in such a tease with the mar­kets by not re­veal­ing its new plan un­til its De­cem­ber 8 meet­ing. Af­ter all, the ECB has con­firmed that it is run­ning out of el­i­gi­ble Ger­man bunds it can buy and so must re­fine its pro­gram. There are sev­eral ways it can do this: one would be to break from the “cap­i­tal key” ra­tio and buy more liq­uid bonds, a pol­icy that would boost its pur­chases of Ital­ian bonds. It seems likely that the rea­son the ECB de­layed such a de­ci­sion is that it wanted to wait un­til af­ter Italy’s con­sti­tu­tional ref­er­en­dum on De­cem­ber 4. The last thing the ECB would want to have done is prom­ise a cap to Ital­ian bond yields just ahead of the coun­try po­ten­tially be­ing en­gulfed in po­lit­i­cal chaos, should Prime Min­is­ter Mat­teo Renzi lose the vote and there­after call a gen­eral elec­tion, which has the po­ten­tial to be fought on the is­sue of the coun­try’s con­tin­ued par­tic­i­pa­tion in the sin­gle cur­rency. Such a sit­u­a­tion would have left it vul­ner­a­ble to Ger­man crit­i­cism that the ECB was dou­bling down on in­creas­ingly risky Ital­ian debt.

For now ris­ing bond yields and a steeper curve are of­fer­ing a respite to Euro­pean banks and have ex­panded the pool of el­i­gi­ble bonds that the cen­tral bank can pur­chase in its QE pro­gram. Still, look­ing at the di­rec­tion of the econ­omy and likely pol­icy re­sponses this seems likely to be a short term correction be­fore the ECB re-as­serts it­self— one way or an­other—af­ter the Ital­ian ref­er­en­dum.